Economy 101: Life Insurance

Life insurance is a contract where, in exchange for you paying regular premiums (commonly monthly, quarterly or yearly), an insurance company agrees to pay a benefit to your designated beneficiaries when you die. Most people purchase life insurance as protection for their families who depend on their income and would otherwise have difficulty meeting current and future financial obligations.

Not everyone necessarily needs life insurance – for example, young single people with no dependents often do not. But life insurance can be an important investment for those whose spouse, children, aging parents or others who depend on their income to help with daily living costs, paying off a mortgage, financing college, funding retirement or other major expenses.

There are two broad categories of life insurance – term and permanent. The cost for each is based on several factors, including your age, gender and state of health. Each is subject to sales commissions and other administrative fees. Such costs are generally much higher for permanent life policies.

Key term and permanent life insurance features include:

Term life. You purchase a policy for a specified benefit amount payable to your beneficiaries if you die within the stated time period (the term) and have paid your premiums. Depending on the policy’s details, you may or may not be allowed to renew it or convert to a permanent life policy after the term expires. Term life is usually the simplest and least expensive form of life insurance, since it pays benefits only when the policyholder dies. Premiums typically increase at intervals, according to age.

Permanent life. With permanent life, your premium remains constant for as long as you own the policy. The initial cost is usually significantly higher than for term insurance with the same death benefit level, but they become closer in cost over the course of many years of coverage. The key difference is that with permanent insurance a portion of your premium goes into a savings or investment fund, whose earnings grow tax-free until borrowed or withdrawn. Among the more common types of permanent life insurance are:

Whole life, which guarantees the death benefit amount, premium amount, payment schedule and the cash value of your account for as long as you carry the policy. The insurance company determines how the investment component is invested.

Universal life offers the same fixed investment performance as whole life but greater flexibility in terms of premium amounts, payment schedules and cash withdrawals.

Variable life (also called adjustable life) allows policyholders to invest the investment portion of their premium in securities (stock funds, bond funds, money market, etc.), which have a greater potential for growth but also carry greater investment risk than regular savings. Poor fund performance can reduce the cash value and/or death benefit, although not below the face value of the policy.

Before buying any life insurance policy, carefully calculate your beneficiaries’ future financial needs should you die prematurely and ask your insurance broker for a full breakdown of any commissions, administrative fees and tax implications.

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